What is APR: Here’s how Annual Percentage Rate works

If you’ve been researching new credit cards or looking at refinancing your home loan, you’ve probably noticed the term APR popping up everywhere. APR stands for the annual percentage rate and, in terms of need-to-know financial information, understanding APR is pretty high on our list.

In this article, we’ll go over the basics of APR–what it is, how to calculate it, and how to improve it — so that you can be an informed borrower.

What Is APR?

APR stands for annual percentage rate. It represents the yearly interest and associated costs of a loan by including loan-specific fees like the loan origination fees or mortgage insurance. You’ll find APR listed for credit cards, auto loans, mortgage loans, personal loans, and most other lines of credit. In fact, lenders are required to disclose a loan’s APR to the borrower thanks to the Truth in Lending Act (TILA).

Because the APR takes into account some of the fees of a loan, APR is often a more accurate representation of the cost to borrow than the interest rate alone.

For example, a mortgage loan may tout a low interest rate through discount points but then has higher fees, while another may have a higher advertised interest rate but lower fees. Interest rates alone may be misleading, so looking at the APR will allow you to more accurately compare the overall cost of these two loans.

Essentially, the higher the APR the higher cost to borrow and vice versa. While not all fees are included, APR is a good place to start comparing lines of credit.

The Two Types of APR

There are two types of APR: fixed APR and variable APR.

Just like it sounds, fixed APRs don’t change. The rate that you locked in at onset of the loan stays with you for the term of the loan. Accordingly, fixed APRs are more predictable than a variable APR. The actual rate you’re offered is dependent on the market conditions (and your credit score) at the time of the loan/application.

While it is possible for this rate to change, the lender is required by the Consumer Financial Protection Bureau (CFPB) to notify you in writing.

Variable APRs are tied to an index interest rate, such as the Prime Rate from the Wall Street Journal. This underlying rate fluctuates with economic conditions and, therefore, variable APRs fluctuate as well. Basically, when the index rate goes up, your variable APR goes up.

Most credit cards use variable APRs and while you can find guidelines in the cardholder agreement as to when the APR can change, the lender is not required to inform you as to when the rate changes.

Credit cards also often have multiple APRs depending on the type of transaction. These different transactions also have different grace periods, a period between the account closing date and your due date where you can pay off your purchases without penalty (aka interest).

The APR Terms You Need to Know

There’s more to understand at our Credit Card 101, but check the glossary below for a quick rundown on how the different transactional APRs typically work.

Each card will offer slightly different terms for each of these, so it is important to check out the cardholder agreement when considering a new credit card.

Purchase APR

Purchase APR is the interest rate applied to the purchases made on the credit card. If you pay your statement in full each pay period, you’ll avoid this all together. Most credit cards have a grace period between the end of the billing period and the date your payment is due. During this period, you can pay off the purchase without incurring any interest. If you do hold a charge over the billing cycle, then the purchase APR is applied accordingly.

Balance Transfer APR

Balance transfer APR is the interest rate charged when you transfer a balance to your credit card. Some cards offer low promotional balance transfer APRs–just be aware that once the promotion is over you’ll be charged the regular balance transfer APR on the remaining balance.

Cash Advance APR

Cash Advance APR is the interest rate charged for the privilege of borrowing cash from your credit card. Normally this APR is higher than the Purchase APR, and there is no grace period.

Penalty APR

Penalty APR is the interest rate charged when you violate the conditions of the cards like making a late payment. Not all cards have a Penalty APR, but if it does, it’s normally the highest APR.

Introductory APR

Introductory APRs are normally very low rates that apply for a set period of time. Just make sure that you know the timeline and what the APR will be after the promotional period has ended.

The Difference Between APR and APY

APR (annual percentage rate) and APY (annual percentage yield) are easily confused with each other. Knowing the differences can earn you big financial dividends and save you from unexpected financial costs.

Both APR and APY are ways to demonstrate interest rates. As we’ve been over, APR is the annual percentage rate and demonstrates the combined yearly cost of interest and fees for a loan. APY is the annual percentage yield and similarly combines interest and fees but also takes into account the effects of compounding interest.

If you pay off your interest from your loan or credit card balance each billing period, then your APR will be an accurate representation of your costs. If you carry a balance, however, then the cost will be more than the APR represents because you will now pay interest on the interest you were charged — aka, compounding interest. That’s where APY, which already includes compounding interest, becomes more helpful.

Because of this, a credit card issuer or bank often is strategic in choosing either APR or APY to represent their product. For example, a credit card will most often advertise the APR because this rate is lower and doesn’t show the effects of compounding interest; it can feel like a lower cost. Again, it’s not a false representation, just a strategic one. On the other hand, a savings account that earns you interest will often pitch you the APY because it emphasizes the growth your money will make.

The important thing to know is that just because you’re seeing the APR doesn’t mean you’re free from the effects of compounding interest.

How to Calculate APR’s Cost to You?

It’s important to understand how much a loan or outstanding balance on your credit card will actually cost you. Every bank has different margins and interest rates, but the overall concept is the same.

For example, say you’re carrying a balance of $700 on your credit card with 25.99% APR. Because the APR represents a yearly rate, you first need to find your daily interest rate by dividing the APR by 365 days.

25.99% ➗ 365 days = .0712%

This means that every day a balance is carried over, you are charged .0712%, which for $700  is approximately 50 cents a day. While that seems small, the interest quickly begins to build. If the card’s bill is assessed monthly, then take that rate and multiply it by the number of days in the month.

.0712% ✖ 31 days = 2.21%

Multiply this new monthly rate by the $700 balance being carried over and holding this balance will cost roughly $15.45 that month.

Before opening a new line of credit, it is worth it to do some simple math like this to understand the cost of that credit.

What Determines the APR You’re Offered?

APR calculations often begin with an index rate that reflects the economic conditions at the time. Credit cards then add a fee on top of that called a margin for using their service. This margin depends greatly on the cardholder’s credit score. People with good credit scores are offered better APRs than those with bad credit scores. Because of this, it’s important to understand how to improve your credit score. There are a lot of ways to raise your score, but here is a list of the simplest and most common:

Establish credit
Pay your bills on time
Keep the balance on your existing cards low

Over time, these small changes can improve your credit score and reduce the cost of borrowing overall.

The Bottom Line

Credit and loans are a part of modern life so APR isn’t going anywhere. While you might be the type of borrower who pays your credit bill in full every month, there may be times in your life when you can’t avoid paying interest completely.  In these moments, understanding APR will help you be an informed borrower.

And as you make those decisions, here’s the key takeaways to keep in mind:

APR represents the cost of borrowing credit, including interest and fees.
Fixed APRs have a set interest rate for the course of the loan while variable APRs rate can change without notice.
APY is different than APR in that it takes compounding interest into its calculations.
Improving your credit score can help you receive a lower–and therefore better–APR.

Frequently Asked Questions (FAQs) About APR

If you’re still thinking about APR, keep reading to see our answers to the most frequently asked questions.

What is APR in Simple Terms?
Basically, APR (annual percentage rate) is how much it’s going to cost you each year to borrow money. It’s expressed as a percentage and includes the interest rate and fees you’ll have to pay to use the loan.
Is 17% a Good APR for a Credit Card?
A good APR is one below the current average interest rate. Currently, the average APR is 14.68%, but credit card companies only offer this to people with good credit scores. Therefore, while 17% is higher than the average credit APR, it is still less than many marketed credit cards, so depending on your credit score, it’s a decent option.
What is a 24% APR?
A 24% APR means that’s the interest rate you’ll be charged over the course of the year for the service of borrowing money. It means that if you carry an outstanding balance of $750 for a year with 24% APR, you’ll pay approximately $180 in interest. The APR does not take into account compounding interest, however, so this cost may be higher if you accrue interest during the year.
What Does 30% APR Mean?
30% APR represents the amount of money you’ll pay to borrow money from a lender. While APR represents an annual rate, interest is often applied monthly or daily. A 30% APR represents a .082% daily interest rate or a 2.5% monthly interest rate.

Contributor Whitney Hansen writes for The Penny Hoarder on personal finance topics including banking and investing.Writer Sarah Kutra contributed to this report. 

This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.